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This was the year when credit crunch turned into financial panic. The Government's strategy for easing the crisis - recapitalising the banks, and taking direct equity stakes in some of them - has been right in principle. But it is increasingly ill-directed.

In trying to meet multiple aims with its intervention in the banking sector, the Government risks failing in the central one: to restore the health of the financial system, and thereby enable growth and investment to resume. It is becoming clear that the recapitalisation is a job half done. In the case of the Royal Bank of Scotland, further recapitalisation and therefore full nationalisation may be weeks away.

The interests of the economy and the taxpayer are best served by helping the banks to recover quickly. That recovery will not be advanced by imposing punitive interest charges on banks in return for public funds, or exerting pressure on the banks to lend more and at lower rates.

Owing to a contagion of bad debts, the interbank lending market has ceased to operate. Businesses are the immediate victims. Enterprises that are competitive in normal economic times are finding their trading operations disrupted owing to a lack of stable lines of credit. John Varley, the chief executive of Barclays, now predicts that the amount of credit available to business will contract for between 12 and 24 months.

This adjustment is inevitable and will be painful. High levels of debt need to be unwound before asset prices stabilise and banks can have confidence in the value of the assets that they hold. But the Government can help to shorten the period of adjustment by focusing single-mindedly on ways to get the banks to lend again. The most immediate is to enable the banks to build up their reserves so that they are confident in lending to each other once more.

This is the rationale for the Government's strategy of directing taxpayers' money to the banks. And because recapitalising the banks necessarily involves overpaying for assets of doubtful quality for which there is not currently a market, the Government is right to require that the taxpayer receive an equity stake in banks that take the money. But it is wrong to link the bank rescue to targets for lending - either in volumes of loans or in interest rates charged - or to charge exorbitant rates for the funds.

It is possible to sympathise with the principle that the banks have failed in their own business and should be held to account. The financial crisis has its roots in bad decisions in monetary policy early in this decade, but its severity reflects irresponsible practices by the banks. In using public funds to rescue the financial system, the Government is also properly concerned with minimising the costs to the taxpayer.

But it makes no economic sense to insist that the banks pass on official interest rate cuts to their customers. The banks do not raise funds at official Bank rate; they borrow at the interbank market rate. Insisting that the banks follow the Government's own stipulations is tantamount to demanding that the banks cut their profit margins. The objection to this stance has nothing to do with free-market dogma. It is that the Government's strategy for rescuing the financial system and the wider economy is increasingly selfdefeating, and must be rethought.